Economics Update (October-December 1998)

Economics Update (October-December 1998)

n recent years, several Latin American countries introduced social security privatization programs. These policy reforms generally require workers to divert all or part of their payroll taxes into individual investment accounts administered by private pension fund companies. These countries' governments hope that social security privatization spurs the development of domestic capital markets and boosts domestic savings rates.

Internationally, these policy reforms have received a great deal of attention as countries throughout the world confront their own challenges related to social security reform.

The Latin American Experience

By the 1990s, state-run social security systems in Latin America faced a host of financial problems caused by aging populations, inflation, ineffective administration, poor investment, unrealistic benefits and widespread tax evasion. For years, politicians traded social security benefits for political support, creating liabilities that were increasingly difficult to finance. Social security surpluses were often squandered on bad investments, and workers often colluded with employers to evade payroll taxes. In some cases, individuals needed political connections in order to collect pensions.

Furthermore, benefits were distributed unequally. Select occupations like civil servants received generous benefits and early retirement, while most workers received meager benefits. For example, until recently Brazil had no minimum retirement age and only a minimum time of service requirement, which varied by occupation. This situation allowed some workers to receive a full pension after only 20 years, while others had to work 35 years to qualify for lower benefits. Compounding matters is the fact that over half of Brazil's workers are in the informal sector — that is, they pay no payroll taxes — and remain outside the social security system.

Social security reform in Latin America is still evolving as governments continue to grapple with changing financial and political conditions.

In the beginning of this decade, many Latin American policymakers turned their attention to Chile, which instituted the world's first pension privatization program in 1981. In Chile's old state-run defined-benefit system (a pay-as-you-go program used in much of the world, including the United States), contributions from workers, employers and the government funded benefits that were fixed at retirement.

In Chile's new private defined-contribution system, all salaried workers who entered the workforce after 1981, except the military and police, are required to contribute to personal investment accounts; the system is optional for the self-employed. Upon retirement, the accumulated funds in individual accounts may be used to purchase an annuity.

Chile's old pay-as-you-go system is being gradually phased out. Workers who previously contributed to the old public system receive compensation upon retirement in the form of government-issued bonds. The transition to a private system is extremely costly because the government is responsible for paying obligations from the old system while payroll taxes are diverted to individual savings accounts under the new system.

Mexico, El Salvador and Bolivia are also shifting to defined-contribution systems. In Mexico's new pension system, started in 1997, workers contribute to individual accounts. Unlike Chileans, Mexicans who contributed to the old public system do not receive compensation based on past contributions. Instead, upon retirement, workers may choose between a pension based upon either what they would have received under the rules of the old system or what they have accumulated in their individual accounts.

By contrast, Argentina, Uruguay, Colombia and Peru switched to mixed public and private systems, where all workers receive a basic state-provided benefit. Contributing to the private system is optional in these countries, except Uruguay, where contributions are mandatory on monthly earnings between $800 and $2,400.

In Argentina, workers have the option of contributing 11 percent of their salaries to the reformed public system or to a private individual account. The 16 percent employer payroll tax continues to fund the basic universal benefit. Unlike Chile's system, Argentina's offers no immediate financial incentive (in the form of lower payroll taxes) to switch to the new system. Past contributions to the public system are recognized, and the military and federal police are exempt.

Features of Recent Pension Reforms

Chile

Peru

Argentina

Colombia

Uruguay

Year implemented

1981

1993

1994

1994

1996

Private system mandatory

yes

no

no

no

yesa

Basic public pay-as-you-go benefit

no

yes

yes

yes

yes

Contribution rate for savings as percent of wage

10

8b

7.5

10

7.5

Commission costs plus insurance as percent of wage

2.94

3.72

3.45

3.49

2.62

a Mandatory for earnings between $800 and $2,400.b Contribution rate will gradually be increased to 10 percent.

In a defined-contribution system, future pensions depend upon each individual's contributions and investment returns. Chilean pension fund companies invest in diversified portfolios that are strictly regulated by the government. These regulations limit the percentage of a fund that may be invested in a given type of financial instrument. Pension funds that consistently deliver significantly below-average returns are sanctioned. Returns are, of course, sensitive to overall market performance and are particularly vulnerable to the threat of inflation.

Since 1981, average real annual returns (after commission costs, which range between 16 and 20 percent of total contributions) have been 11.2 percent. With the recent downturn in Chile's equity markets, the country's pension funds dropped 9.9 percent from January through September 1998.

The Chilean government recently took steps to address two persistent problems: high administrative and commission costs and a lack of diversity in investment options. High administrative costs have resulted in part from high marketing costs as pension companies compete for the 25 percent of Chilean workers who switch from one company to another every year. The government is trying to remedy this problem by making it more difficult for workers to switch companies and encouraging reforms that would lower commission charges.

Until now, pension fund companies have been limited to offering just one investment portfolio even though individuals tend to have different tolerances for risk according to their ages. The government now wants pension funds to offer workers a choice of portfolios composed of stocks and/or fixed-income investments.

Social security reform in Latin America is still evolving as governments continue to grapple with changing financial and political conditions. Countries throughout the world that contemplate similar reforms will be paying close attention to the Latin American privatizations. But the long-term performance of the reformed systems will not be tested until a generation of workers that has labored under these new systems retires.